Carve-out transactions present unique opportunities for established businesses looking to streamline their operations and to raise capital through the monetization of non-core assets, but also present unique challenges that call for specialized professional advice and careful planning.
What is a Carve-out Transaction?
A "carve-out" transaction usually involves the sale of a specific business line, unit or division. These transactions can take many different forms, from divestitures of entire business segments to sales of single brands, but the defining feature of a carve-out transaction is that the assets to be sold are at least partially integrated into the operational structure of the seller and its related entities (and thus need to be "carved-out").
Current market conditions are leading many companies to take a hard look at their business and adjust their strategic focus or seek new capital to adapt to our new realities. Further, with private equity "dry powder" rising to record levels and extremely low interest rates, sellers looking to offload quality assets should find a receptive audience of both strategic and financial players. As such, we expect there will be many opportunities for carve-out transactions in the near to medium term.
The Importance of Careful Preparation
The sale process for a carve-out transaction is often strategically and legally complex. In our experience carve-out transactions require significantly more preparatory work and larger internal and external deal teams than customary M&A processes.
On the seller side, internal preparation is one of the factors that is within the seller's control and that can support value creation. By identifying potential issues from the outset, the seller can proactively plan workarounds or, if not resolvable, manage any resulting price impact by properly planning the disclosure of identified issues. On the buyer side, planning for post-closing integration has to be part of the planning of the acquisition as having a comprehensive view of the carve-out and how the buyer can efficiently integrate the carved-out business in its structure is the only way to ensure that the deal delivers on its promise. In any case, due to the fact that carve-outs often involve a longer-term relationship between the seller and the buyer than typical M&A transactions, special consideration should also be given to building an efficient working relationship between the parties at the table, and for this, thorough preparedness always helps.
The Carve-out Process
The first key step of a carve-out transaction is to precisely identify the in- and out-of-scope assets and related liabilities. This will ultimately impact each step of the transaction and help the parties determine the best structure for effecting it. In fact, the impact of the asset and liability mix can have such far reaching impacts on the unfolding of the transaction that it is often advisable to scope out different potential allocations when planning an auction process, particularly where buyers with different kinds of perspectives (i.e., strategic and financial) are expected to participate.
The location of the carve-out assets and related liabilities within the existing corporate group, as well as such factors as business continuity needs, tax planning, existing integrations, potential synergies and required third party consents and governmental approvals will all impact the parties' preferences for transaction structuring. The identification of such considerations is an important step of the planning stage, and again it is important for sellers to realistically consider buyer preferences so as to be able to scope and assess different scenarios as much as feasible before sitting down at the bargaining table.
Pure share deals, where a contained business is fortuitously housed in a stand-alone subsidiary that can be cleanly sold off, are rare, but even in cases where simpler structures are possible, carve-out transactions inevitably contain asset deal style terms to address items such as shared services or commercial arrangements, sufficiency of assets and contingency plans for assets or liabilities that may be discovered in the "wrong pocket" post-closing. Furthermore, regardless of transaction structure, arrangements generally need to be contemplated for post-closing de-integration of the transferred business which may require transitional or ongoing service or other business arrangements.
Areas of heightened concern or friction in carve-out transactions tend to include:
- Financial statements: in addition to being a long lead time item and involving complex accounting considerations, carve-out financials can directly impact transaction valuations and are therefore often subject to increased scrutiny. Representations and warranties regarding carve-out financial statements also require special attention given the particular basis on which such financial statements are prepared.
- Transitional services agreements: these are a usual feature of carve-out transactions and can be key to the buyer supporting its valuation, achieving business continuity and successfully integrating the carved-out operations. Parties are well advised to consider key TSA terms from the outset. While the purchase agreement drives the headline numbers for the transaction, the TSA can have a significant impact on the bottom line for both sides and leaving its negotiation to the last minute will create uncertainty and risk.
- Employees and employee benefits: in addition to agreeing on the universe of transferred employees, the buyer and seller will also need to allocate responsibility for any obligations, such as severance payments, arising in connection with employee transfers in the transaction. Other areas of potential HR-related issues in carve-out transactions are tied to the requirement that the buyer offer substantially similar benefits to the transferred employees post-closing, the potential for the transfer of union accreditation and potential risks of "osmosis" between employers when premises and certain functions are shared post-closing.
- Intellectual property: similarly, untangling IP rights as between various business units that make use of them can require considerable due diligence and planning on both side and can create significant roadblocks if key items (such as group-wide enterprise software and IP shared among business units) cannot be effectively delineated or shared post-closing.
- Ongoing intercompany arrangements: where carve-out assets historically derived a significant portion of their value from favourable terms within the seller's vertically integrated supply chain, the contractual parameters for the carve-out business' ongoing post-closing participation in that supply chain often requires careful consideration and may have significant impacts on valuation, including where the buyer does not have an existing or comparable infrastructure.
- Real estate: carved-out businesses often do not operate on a structurally standalone basis, such that there may not be a clear division of real property as between the carved-out and retained business units. While the most straightforward solution from the seller's standpoint may be to require the buyer to relocate the carved-out business, this can be a major source of business disruption and create valuation issues, such that complex co-ownership, leasing or subleasing arrangements may be necessary.
Where Experienced Advisors Can Help
The levels of planning, due diligence, and coordination among professional advisors and transaction parties that is required in order to execute a successful carve-out transaction is in our experience significantly higher than that of an ordinary acquisition. It is therefore critical for the buyer and the seller to surround themselves with a core team of experienced legal, finance and operational professionals.
On the business and operations side, depending on the complexity of the carved-out business and the buyer's internal resources and integration experience, it is often advisable to use consulting firms to assist with the operationalization of carve-out transactions. From an external legal advisor standpoint, carve-out transactions require close collaboration between the core M&A team and the various internal and external specialists, such that working with counsel who is experienced in the nuances of carve-out transactions can make a difference in respect of overall transaction efficiency and success.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.